Is Rehypothecation a Systemic Risk or One-Off Occurrence? And Why Does It Matter to Metals Markets? Part One

Two days ago, a friend of mine dropped me a note asking me what I knew or had heard about a rehypothecation scandal involving metals or industrial metals. Rehypothecation? I’m supposed to know what rehypothecation means?

Quick check on Wikipedia — ah yes: “Rehypothecation is a practice that occurs principally in the financial markets, where a bank or other broker-dealer reuses the collateral pledged by its clients as collateral for its own borrowing. Well, call me crazy, but that certainly sounds like sub-prime-CDO-mumbo-jumbo to me.

Now let me refer you to a more intelligent source that also broke the story, Zero Hedge. I love Zero Hedge (though I have to read each story twice to actually comprehend it), but another source would better convince me the issue might have some merit wait here comes one from Reuters released on Dec. 7.

The short of the long goes something like this: MF Global (see our previous story on the downfall of this commodities firm), taking a page from Enron, used an off-balance sheet transaction called a repurchase-to-maturity better known as a “repo.” According to this New York Times piece, repos allowed MF Global to “classify the purchase of bonds [European sovereign bonds] as a sale, rather than a risky bet subject to the whims of the market. These repos ultimately led to the downfall of the firm.

FINRA (Financial Industry Regulatory Authority), the federal regulatory body that oversees firms like MF Global, grew concerned and forced the firm to set aside $200 million in case its bet went the wrong way. And that was the beginning of the end for MF Global, according to the Times.

Back to Rehypothecation

But the issue of rehypothecation only appears in the story later. As we know from the Lehman Brothers example, once the ratings agencies weigh in and a company’s stock starts to tumble, the firm has to grab as much capital as it can. Like Lehman, the firm would split into bits and pieces.

Only when MF Global ultimately filed for bankruptcy, and all of the secured and unsecured creditors started buzzing, did we begin to understand that MF Global (along with many other banks and investment houses) regularly engage(d) in this practice.

At issue, according to Zero Hedge “was MF Global using rehypothecated client gold to satisfy liabilities? To answer that question, HSBC has filed a lawsuit (see the second link in this post) against the firm to determine the rightful owner of physical gold.

And that all brings us back to the questions my friend posed — and which we now ask:

  1. MF Global (actually, its UK subsidiary) owns 4.7% of the LME. Given that the firm “was a Category 1 commodity broker (e.g. ring trader), to what extent did “metals underpin any of this rehypothecation?
  2. Based on all of our reading, the metals involved appear to include gold and possibly silver. But what about copper and other commodities such as oil?
  3. We have seen some accounts that some of the gold in dispute may reside in ETFs. We have yet to confirm or disprove the validity of this claim.

Next we’ll take a pass at the title of this piece systemic risk or one-off occurrence. Sadly, if we have learned anything about the sub-prime mess, we know that both the lending practices as well as the packaging and selling/re-selling of CDOs spread far and wide (i.e. systemic). We know many banks make use of rehypothecation to the tune of billions of dollars.

We’ll do a follow-up on this story as information becomes available, particularly as it relates to metals and what that could mean for metals prices in the medium to longer term.

–Lisa Reisman

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